Debt & Hybrid Funds Lose (DHFL)

The past week has been a tumultuous roller-coaster ride for many debt & hybrid mutual fund investors. Dewan Housing Finance Limited (DHFL) has been the key culprit behind the ensuing drama.

DHFL’s decision to delay interest payments to NCD holders on 4th June triggered a series of downgrades to “default” from credit rating agencies.

In turn, all mutual funds that had invested in various debt offerings from DHFL had to write-down their investment value by 75%, in-line with SEBI haircut guidelines. A write-down is equivalent to booking a loss on paper by reducing the asset value.

According to Moneycontrol, 254 schemes had exposure to DHFL debt - and in some instances, this write-down meant a fall of 40-50% in NAV of certain mutual funds.

This isn’t how Debt Mutual Funds are supposed to behave - or so most of us believe. But the harsh truth is that there are all kinds of debt funds, and most of them can actually find themselves in such messy situations since their fund guidelines allow them to do so.

Broadly speaking, there are 2 kinds of debt:

Government debt - this happens when countries borrow money by issuing debt instruments. Such debt is considered to be ultra-safe, mainly because as a last resort, the government can always print additional money to repay its obligations.

Corporate debt - when companies borrow money to finance various projects/operations, such debt is called corporate or commercial debt. Compared to government debt, corporate debt instruments are riskier, since a company cannot really print money to take care of its obligations in the worst case.

Companies have to rely solely on their business activities to ensure it repays borrowers. This additional risk is why they pay higher interest rates than government debt of similar maturity.

Most people investing in Debt Mutual Funds realise that they’ll receive slightly higher returns than FDs - but many also feel (and have been told) that they are almost as safe as FDs. That’s just not the case. Other than some handful debt oriented MFs that are mandated to invest in Government securities and/or other short-term liquid instruments, most debt mutual funds can actually take exposure to various kinds of corporate debt.

And most MFs do so in order to distinguish themselves and achieve higher returns - it’s not a surprise that out of the 360 Debt & Hybrid MF schemes (excluding Gilt & liquid/overnight schemes), 250+ schemes had invested DHFL paper.

Recently, “Corporate FDs” have also become quite popular. Similar to Debt MFs, these are also verbally marketed by many offline distributors as “almost as safe as FDs” - but the truth is that corporate debt instruments have much higher default/credit risk than FDs. Moreover, Bank FDs are insured up to ₹1 lakh while “Corporate FDs” don’t come with such protection.

Events like the DHFL saga are indeed not common - but that doesn’t change the reality that companies do get into troubles for all sorts of reasons. Is the 1-2% additional returns worth the additional risk, especially for debt/fixed-income securities?

In my opinion, it’s not worth for most retail investors - whose primary goal of investing in fixed-income is to get risk-free returns. Beyond FDs, Government Debt, and Liquid/Overnight funds - the increased risk that comes with corporate debt stops serving the primary purpose of many retail investors.

If at all the objective changes to earning additional income, investors can turn to asset-allocation and get some additional returns & diversification benefits by investing part of their portfolio in other asset-classes like equities and/or gold. You can learn more about constructing portfolios using asset allocation in this post.